A More Innocent Explanation For Betting Against A CDO That You Intentionally Stuffed With Crap Assets

ProPublica's report
on the hedge fund Magnetar
-- which had a hand in stuffing CDOs with crap mortgages and then
shorting said CDOs -- is attracting a fair amount of predictable
outrage. On the surface the details make the fund look scummy.

Casually, it sounds like their strategy was: Put together a
stacked deck, and then find some sucker to play cards with.

The story is told as though they saw this big crisis coming, and
that it was just a matter of finding the most efficient way to
take advantage of everyone else's misery.

But Magnetar (like Paulson, etc.) didn't see a huge
crisis coming. What the story shows is that they thought a very
specific, and ultimately narrow, slice of mortgage-related assets
would go very bad.

After all, if they'd actually seen this crisis coming, all they'd
have to have done was short Citigroup or something like that, a
bet that would have required far less work or salesmanship.
(This is a point Holman
Jenkins made in his Hoover Institute report published last
summer.)

Again, the reason they didn't put on a wholesale short of the
financial system is that it didn't occur to them this would prove
very profitable.

Basically, they were looking for a leveraged way to bet against
housing, and so they figured that the best way to do that was to
bet against the very riskiest slices of this market. Obviously
such bets weren't readily available. Fortunately for funds like
Magnetar, there were yield-hungry buyers (thank you demographics
and Alan Greenspan) willing to make the opposite bet (plus
ratings agencies that weren't very forward looking).

It's easy to think in retrospect that a bet against subprime was
implicitly a bet on the entire system collapsing, but that's
ex-post facto thinking. Well after folks became aware of the
subprime issue, the general thinking was that subprime itself was
too small to cause major waves.

Take for example
this post from Yves Smith written on July 10, 2007,
responding to Chuck Prince's lack of major concern about
subprime. And bear in mind that Yves is now known as someone who
was critical of Wall Street before it was cool:

[The] subprime meltdown in and of itself isn’t an event of
sufficient magnitude to cause a full blown credit contraction.
But there are events on other fronts that are pointing to
lessening liquidity: the Japanese finally showing
some concern about the carry trade; India, another liquidity
provider, going through several rounds of interest rate rises to
staunch domestic inflation that has resulted from buying US
dollars (buying dollars increases the domestic money supply
unless the government “sterilizes” it by issuing domestic bonds
to soak up liquidity); the
Chinese and
Gulf states showing signs of domestic inflation and
reluctance to keep buying more dollars.

So even someone like Yves, a leading critic, figured that
subprime issue was too small, but that the undoing of Wall Street
could come from Japan, India, or possibly the Gulf states.

As we know now, subprime turned out to be the seed of a massive
crisis that's still with us, but that just obvious even as late
as the summer of 2007 (and arguably it wasn't obvious even in the
summer of 2008).

Had Magnetar known of the huge crisis coming, it would have just
bet against Citi (or certainly Countrywide). Instead, it
saw a narrow problem unfolding and sought the proper security for
that. And that's all.